The Mexican peso is no stranger to external shocks. For many years, it has been considered a proxy for investor sentiment around emerging markets. And during the latter part of the US presidential campaign, the peso became a gauge for Trump´s chances of winning the presidency.
It came as no a surprise when in January this year, right after Trump took office, the peso hit an all-time low at MXN21.95 against the US dollar. As the relationships between the neighbouring countries tensed and Trump continued to press for trade renegotiations, the peso tumbled by 17%, making it the second worst performing currency in the world after the Turkish lira.
To counter the drop, Mexican authorities have taken a more hands-on approach and carried out a series of measures in an effort to shield the peso from further volatility and stifle inflation.
This represented a significant shift in monetary policy in Latin America’s second largest economy, which has been one of the staunchest advocates of a free-floating exchange rate in the emerging world.
Since last year the Central Bank hiked the interest rates by 325bp, from 3% to 6.25%, and during the first months of 2017, it also sold dollars in an attempt to rescue the peso, which left a significant dent in the country´s reserve. Neither one of these strategies proved effective as the peso kept tumbling.
Showing its more creative side, the Mexican Central Bank (Banxico) announced a US$20bn currency hedging plan that would allow monetary policymakers to rescue or at least protect the slumping peso without dipping into its foreign reserves.
“In recent months the peso has shown a high degree of volatility in exchange rates against the US dollar, which is not consistent with the country’s economic fundamentals,” Banxico said upon announcing the programme.
The programme involves an initial auction that took place on March 6 with up to US$1bn in FX contracts up for grabs; the Central Bank offered six different maturities for the contracts – which are similar to non-deliverable forwards that pay in pesos – ranging from 30 to 360 days.
At the request of the Security Exchange Commission, the Central Bank will allow financial institutions to purchase exchangeable hedges, which will be payable at maturity, from the Central Bank via auction.
Ramon Aracena, the Chief Economist at Institute of International Finances (IIF), believes this is good news for the peso – and the market seemed to agree, as the peso rallied on March 6 to a four-month high to MXN19.4350 per US dollar, its strongest point since the day after the US elections.
According to Aracena, the programme will give the government more room to intervene and sustain the peso.
“Mexico is a country with a healthy amount of foreign reserves, but which has suffered from the continuous attacks of Donald Trump,” he noted.
“It is always better to have more options at your disposal than no options at all,” the economist concluded.
While selling US dollars had eaten into the country´s foreign reserves, the hedges are settled in pesos and are reflected on the Central Bank’s balance sheets. Institutions and investors that participate may be betting on the peso’s depreciation, while others may just want to lock in a specific exchange rate in futures.
Among those are Mexican companies, especially those that have expenses in dollars and revenues in the local currency, which have increasingly struggled to service their overseas debt as the currency weakened. This new mechanism will allow them to hedge against further currency shocks.
The peso received another boost when the US Secretary of Commerce and top negotiator, Wilbur Ross, told CNBC that the US had “put in place lines of credit between the central banks” to stem currency outflows. “We need to think of a mechanism to make the dollar-peso exchange rate more stable,” the former investor said.
Even though Agustin Carstens, the governor of the Mexican Central Bank, quickly shut down the idea of asking the US for help, it would represent an improvement in the US-Mexico relations that will ultimately reflect on the FX rate.
“In a conclusive manner, I can say that the Mexican Central Bank has not even thought of asking for a Federal Reserve swap line,” Carstens told Bloomberg.
While also denying plans of any managed exchange rate, he emphasized the Bank’s plan was not to pursue a specific exchange rate level.
“We have a floating rate regime, so the most important thing is not a foreign exchange rate target”.
Maintaining the Peso Could Come at a Cost
Mexico is not the first country in Latin American to turn to this sort of mechanism amid a swift currency devaluation. Brazil used a similar intervention programme in 2013 to support the real after the currency hit a five-year low in the midst of one of the worst economic recessions in the country’s history.
The Brazil FX swap programme reached a peak of US$116bn outstanding in early 2015 with the current short dollar position outstanding being US$26bn.
However, even if this programme helped prop up the real, the country quickly discovered that this sort of scheme comes with a fiscal cost, something Mexico should be weary of.
“This type of programs always come with a fiscal cost,” Aracena explained. However, he admitted that the negative effects of these operations will depend on the period in which they are carried out.
“The consequences it might have in the future depend on how the transactions are done in the long run. If they decided to do this for the next ten years, then of course it will have an adverse effect, but for now we are seeing a very limited amount of hedging. This why today I see more positive aspects than negatives ones”.
Observers are split to say the least. Even though this programme will not touch the country´s reserves, some analysts are not convinced that it will be sufficient to protect the US$230bn capital portfolio, while others are sceptical that this sort of action is enough to shield the exchange rate from the impact of developments in US politics.
Regardless Aracena believes it was the right call for the government. “Right now, Mexico is buying the stability of the peso,” he concluded.